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Friday, September 29, 2017

Thong Guan Industries - Preferred Pick in The Sector

We recently met with TGUAN?s management and came away feeling confident on its future prospects. Capacity is expected to grow by 13-15% in FY17-18E while CNP margins are stable at 7-8% in FY17-18E. As such, we maintainour earnings estimates. TGUAN is now our top pick in the sector, as it is a laggard (-5% YTD) despite having stable fundamentals. Maintain OUTPERFORM with a higher TP of RM5.67 (from RM5.40) and higher PER valuation of 15.3x (from 14.6x).

Growing through stretch film. Thong Guan?s main and premium product is stretch film (c.58% of total capacity in FY18) which is used for wrapping pallets. The group produces (i) thin gauge cast hand wrap (CHW), (ii) thin gauge MaxStretch film, and (iii) the latest line Nano-33, coming in 2H17. Due to growing demand from the global stretch film market arising from: (i) the need for increased automation (i.e. Industry 4.0) and (ii) requirements for smaller pallets, resulting in increased use of stretch film, the Group is planning to increase its stretch film capacity by 44% by end FY18. Besides stretch film, the group is expanding its PVC food wrap line targeting one more line by year-end (6% of total capacity), and another 5 layer blown film line accreting mostly in FY18. All in, we expect capacity to grow by 13-15% in FY17-18E.

Margins stable, will only get better in the long run. TGUAN has been maintaining consistent EBIT margins of 8-9% since FY16 on better product mix, (vs. 2-6% from FY13-15), while we notice that industrial packagers (i.e. TGUAN and SCIENTX)?s FY17 margins were more stable vs.consumer packagers, likely on better cost management strategies and economies of scale. Going forward, we are expecting EBIT margins to remain strong at 8-9% in FY17-18E on higher expenditure and improvements over the longer run, driven by the increase of higher margin products (i.e.Nano-33 stretch film and MaxStretch), on higher sales to Europe, Australia and New Zealand, and PVC food wrap, while the group is not keen on increasing capacity for its lower margin products (i.e. compounding segment).

Maintain earnings. We make no changes to earnings as we have previously accounted for existing capacity expansion, and expect utilisation rates of 79-73% in FY17-18E. TGUAN is targeting RM40-40m capex in FY17-18E, and as such, we are expecting effective tax rates of 12-15% from tax benefits, translating to 13-14% earnings growth in FY17-18E of RM60.0-68.2m. We like TGUAN?s strong net cash position of 0.14x which is better than its peers, save for SLP (refer overleaf).

Attractive valuations, a laggard vs. peers. Despite solid earnings and fundamentals, and being the only plastic packagers that met expectations this quarter, TGUAN?s share price performance (-5% YTD) remains a laggard vis-�-vis its peers which rallied by 4-42% YTD.

Maintain OUTPERFORM on higher TP of RM5.67 (from RM5.40). We maintain our FY18E FD EPS of 37.1 sen but increase our Target PER to 15.3x (from 14.6x) post re-evaluating our plastic sector PER valuation (refer to our report dated 29th Sept 17, ?Taking A Breather, Selective On TGUAN?). Post our analysis and on a conservative applied PER of 15.3x vs. other plastic packagers under our coverage of 17.4x to 19.6x, TGUAN warrants an OUTPERFORM call as its fundamentals are intact with attractive upside. We like TGUAN for its consistent earnings and positive future prospects as we expect expansion into higher margin production lines to sustain margins going forward.